Changes to how dividends are taxed in two of the last three years mean the tax picture for small-business directors is becoming increasingly complex. Being truly tax efficient with salaries also means considering annual National Insurance Contribution (NIC) thresholds. Quite quickly it can become overwhelming and we see many businesses who become lost in the fog of what is and what isn’t efficient. No need to panic though, clearing the fog isn’t as complex as it appears, and small businesses have more than one approach to take to achieve tax efficiency.
It is worth noting before we go any further that if your work is covered by IR35 most of the below won’t be applicable. If this is you, get in touch to see how we can help.
How Are Salaries and Dividends Taxed?
Before we delve any deeper into the approaches you can take to achieve tax efficiency it is always useful to get some context. Understanding how salaries and dividends are taxed should always be your first step when investigating optimum salaries.
For the 2018/19 tax year, the Personal Allowance is £11,850, meaning you can earn up to that amount before being taxed. After that, anything you earn is taxed at 20% up to the higher threshold of £46,3560 where it is taxed at 40%. Above £150,000 it is taxed at 45%.
The Dividend Allowance means that a person’s first £2000 of dividends are tax-free. If you have any remaining space in your Personal Allowance (£11,850) then that value of dividends will also be tax-free. After that point dividends are taxed at a rate of 7.5% up to the higher earnings threshold of £46,350. This band is taxed at 32.5% and anything above £150,000 is taxed at 38.1%.
Armed with this information we can now take a closer look at how you can combine these allowances and thresholds to achieve maximum tax efficiency.
The Traditional Approach Still Works
Traditional approaches to optimum salary levels for directors are based around taking a low basic salary with the deficit being made up with dividends. This is a well-used method and for good reason. It provides tax efficiency for the business as well as the individual.
The optimum salary for this approach is up to the NIC threshold of £8,424. Being this low it also doesn’t incur income tax as it is well below the Personal Allowance. Whilst being low, the income is above the National Insurance Lower Earnings Limit, this helps to ensure entitlements to state pension and benefits in the future are protected. Furthermore, the salary is also a tax-deductible expense for the business. Corporation Tax is saved at 19% on the gross salary. Any further income is then paid as dividends which will make use of the remaining Personal Allowance and benefit from a tax-free band of £2000 as we have already seen, as well as generally lower tax rates above that.
To sum up; the optimum salary in this scenario is £8,424 with the difference made up with dividends.
How Claiming Employment Allowance Can Help
Employment Allowance, first introduced in April 2014, will refund any Employers’ National Insurance Contributions your company pays up to a value of £3,000. For you to be eligible you must not be caught by IR35 and not the sole director or employee of your company. If you’re not sure, we can help you find out if you’re eligible and help you claim if you are.
Using Employment Allowance, it may be more tax efficient to pay above £8,424, but below the Personal Allowance of £11,850. In essence, you can pay up to £11,850 per year, pay no income tax, and the salary is still deductible against the company’s Corporation Tax bill. You would still supplement this salary with dividends as in the first scenario, but these would not be eligible for any Personal Allowance as this has already been used on the salary but would still benefit from the Dividend Allowance of £2000.
One detraction is that this salary would then be eligible for Employees’ NIC, which at £11,850 per annum would equate to £411.12. The Employers’ NIC of £472.79 would be refunded by the Employment Allowance. There are also savings to be had in Corporation Tax at this salary level, dependent on other variables.
To sum up; if you’re eligible for Employment Allowance, the optimum salary is £11,850 with the difference made up with dividends.
What Do You Do Now?
As we can see, it is not quite as simple as saying ‘here is the optimum salary for the current tax year:’. Whilst we can work within the confines of NIC thresholds and Personal Allowance limits, whether companies are eligible for Employment Allowance will also have a significant effect on their tax efficiency. Likewise, there can be different levels of savings to be had with Corporation Tax as well, but this is a more complex, case-by-case situation.
Introducing dividends is a smart way to make use of the Dividend Allowance, as well as lower rates of taxation, but it also introduces further levels of complexity. If you want to make sure your business is being as tax efficient as possible, whether you’re a team of one or have a few employees, get in touch today and we’ll get you on the right track.
If you want to find out how the recent Autumn Budget 2018 will affect your business, you can find out here.